What Does the Acquisition of Treasury Stock Do to Shareholders' Equity?

What Does the Acquisition of Treasury Stock Do to Shareholders' Equity?
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When a publicly traded company earns a profit, its profits are shared by investors who own company stock. Some companies distribute earnings directly to investors in the form of stock dividends.

However, some companies use part of their earnings to buy back shares of their own stock. When that happens, such shares are categorized as treasury stock. Unlike in the case of stock splits, investors usually benefit through higher share prices during acquisition of treasury stock even though share buybacks actually reduce total shareholders' equity.

Treasury Stock vs. Outstanding Stock

When a company files for incorporation with the government, the government approves a certain number of capital stock for issuance to the public.

According to the Cornell Law School Legal Information Institute, outstanding stock represents the total number of shares that are actively held by external and internal investors (held as common stock and restricted stock) who may or may not have voting rights. It can be traded on the secondary market or stock exchange for the current market value.

However, treasury stock doesn’t belong to that category anymore since it is no longer available within the secondary market. Typically, treasury stock represents the stock shares the company is approved to sell but that are not owned by stockholders.

The company’s acquisition of treasury stock may be done for various reasons. It may buy them back for resale or reissuance in the future or to keep them permanently out of circulation from the market.

For example, suppose a company is approved to sell 100,000 shares of stock. In that case, if it sells 50,000 shares to investors, it will have 50,000 shares of treasury stock and 50,000 shares of stock outstanding.

Share Buybacks

When a company chooses to buy back its own shares, it decreases the number of shares outstanding while simultaneously increasing the amount of treasury stock it owns.

It is worth noting that each share of outstanding stock represents a percentage of ownership in the company. Therefore, share buybacks increase the ownership percentage that each remaining share of outstanding stock represents.

However, stockholders' equity is actually simultaneously reduced. To understand this, you must first understand what stockholders' equity is.

Stockholders' Equity

Stockholders' equity is similar to equity represented by your home. Homeowners' equity represents the difference between the amount you owe your loan company and the amount you can sell your house for on the market.

Likewise, stockholders' equity is the value of the company owned by shareholders after all company liabilities have been subtracted from company assets, and it is what will be left over for division among everyone should the company undergo liquidation in the future.

Share Buyback Effect on Stockholders' Equity

You can find a company's stockholders' equity section on its balance sheet. The U.S. Securities and Exchange Commission notes it’s usually included on the right side of this financial statement under the company's liabilities or near the bottom of the statement if columns aren't used.

To arrive at total stockholders' equity, company accountants add the number of outstanding shares to retained earnings and then subtract the cost of its treasury share acquisition for the quarter if any.

When considering the way cash flows, remember that when a company does treasury stock transactions and acquires new treasury shares through a buyback, it spends some of its cash. However, cash is an asset, and changes to it will therefore affect stockholders' equity.

Thus, the increase or purchase of treasury stock actually reduces total stockholder equity by the total amount it cost the company to repurchase the shares for the quarter (treasury stock acquisition cost).